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The backdrop of this claim is that the USD has found its mojo and technical set-up has been widely noted with the USD index finding solid buyers off the 2 February trend support. This has been aggregated with clear divergence alongside the oscillators. The Federal Reserve was the fundamental catalyst needed to pull the USD out of the doldrums, with their clearly hawkish assessment, at least relative to market pricing the trigger. The fact the USD was so unloved was perhaps the biggest red flag to traders and one would expect some mean reversion in positioning to occur in the short-term

The question seems to be around whether we are in for a period of USD outperformance? There is certainly an elevated risk this materialises, and if trading is by and large a play on probability, I would be looking at USD longs with increased convictions. USD/JPY notably should get close attention and there is scope in the coming 24 hours for the pair to push into the bottom of the cloud at ¥110.83.

Of course, today's Bank of Japan meeting (no set time) poses a risk, but little is expected in the way of catalysts, although we have seen some commentary of late from BoJ members and a focus on its ‘exit strategy’. I would take a more neutral stance on AUD/USD and although we saw selling right from yesterday’s Aussie employment data (with the pair hitting $0.7632), the trend just isn’t there at the moment and the buyers are still far too prevalent.

If we are going to take a bullish view on the USD, of course, we need to focus on the US fixed income and rates market and this is where the USD found its inspiration. Nominal bonds yields across the curve have found reasonable selling activity, with the ten-year US treasury up three basis points at 2.16%. However, importantly, if we look at ‘real’ (or inflation adjusted) bond yields, which really are the key driver of short-term currency valuations, we saw a strong reaction with both the ten- and five-year ‘real’ yield moving up seven basis points.

We have even seen underperformance from long rates, and thus, the US yield curve has steepened somewhat, which is something we haven’t seen for a while! I would be focused on the market-based measures of inflation expectations and we can see five-year inflation expectations (I’ve looked at US five-year swaps) have dropped five basis points (or 0.05%) to 1.83% - the lowest since October. In fact, this is not a new trade and inflation expectations have fallen 44bp since January.

So we have rising real yields, a potentially rising USD, falling inflation expectations and a focus on falling credit supply. What could go wrong? Not much, according to the equity market who are still happy to buy the dip and are seemingly happy to do so, as long as high grade and investment grade credit spreads remain at such low levels. Equity follows credit. It does feel that some element of caution is warranted if this dynamic continues. I would be focused on emerging markets, so the EEM ETF (iShares Emerging Markets ETF) looks like a good short here, with a stop above $41.60. In FX, USD/MXN has been in a textbook downtrend, but this trend could find some upside in the short-term. I am surprised we haven’t seen the US volatility Index (‘VIX’) up more than 2.4% and while the S&P 500 has not really moved too greatly, there has been a rotation into more defensive sectors.

Asia looks interesting for the final day of the trading week. Japan is your natural hedge against USD appreciation, so this is where we could see outperformance today. However, macro-traders will be focused on commentary from the BoJ and will be keen to watch moves in the Japanese bond market. The ASX 200 should find buyers, with SPI futures up 20 points and our call for the cash market is to open at 5777. Don’t expect energy or materials to offer any real support, with BHP’s American Depository Receipt (ADR) closing down 1%, with Vale’s US-listing closing down 1.4%. Healthcare is still where the momentum trade in the Aussie market is focused, although the outperformance this week has come from REITS, with consumer discretionary having a better time of it. All things being equal and open at 5777 would see the market up 100 points on the week and undoing much of last week’s 1.9% sell-off, so a close above 5788 (the previous Fridays close) would be somewhat of a positive.

Materials have lagged this week and investors have taken a cautious approach to this sector again. Certainly some of the dynamics in China (a falling credit impulse, real estate sales and a slower pace of money supply growth) have been noted. The leads are somewhat mixed, with spot iron ore closing up 1.5%, while Dalian iron ore and steel futures have gained 1.4% and 1% respectively. US crude looks interesting though, with front-month contract now keenly eyeing the 5 May low of $44.13 – time for OPEC to start jawboning with a greater urgency to support prices? I would suggest this is certainly an increased risk for those holding short positions in crude futures.

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